One Investors Junk Could Be A Penny Stock Investors Treasure

I was sitting with an acquaintance this past week at the dinner table. His vocabulary is chock full of clichés. It’s not that he thinks he made them up. I’m sure he knows that he’s uttering sayings people have been privy to for hundreds of years. I imagine he thinks inserting them into conversations will illuminate an idea or simplify it for us.

As we were sitting down he looked at a recent garage sale find and wisely chirped, “One mans junk is another mans treasure.”

That said, not all supposed "junk" should be discarded. A number of analysts have been saying that the current stock market rally is dominated by so-called “junk stocks”. One writer noted that the biggest winners since mid-July have been the companies with the most beaten-down shares and the ones whose business outlooks are seen as the riskiest within the Standard & Poor's 500 Index.

The biggest gainers have been dominated by 81 S&P companies with unspectacular credit ratings of "BB" or lower, also categorized as high-yield "junk." The stock prices of these junk-rated companies have jumped on average by between 21% and 29.5% betwee
July 10 and August 4. By comparison, investment-grade companies rated "BBB" or above that have seen their shares rise between 9.50% and 19.25%.

While the current rally has a similar feel to the moves seen during the massive March rebound, some investors still argue that the rally is not sustainable without the participation of “higher-quality” companies.

But for those who have been investing in penny stocks for any period of time, it is not uncommon in a recovery for small cap stocks to typically lead the way when the markets bounce back.

Said one analyst, "There are those who will say this is a low-quality rally, but I have to say that I don't know what people's expectations are -- a 50% rally in five months is anything but lousy."

In a recession and a falling stock market, companies with lower credit ratings and more leverage get punished the most. It follows then, that when things improve, those stocks have the most room to run. Conversely, the strongest companies with higher credit ratings tend to weather bad times better so when the economy improves, their stocks usually don't skyrocket.

As for the current “junk stock” rally, another analyst said, "It seems to me that if investors are willing to put more money into companies with shaky finances, that's a good sign -- not a bad one."

"Investors are probably getting out of these bastions of safety, like the Wal-Marts of the world, and moving into things with more leverage, more risk," he added. "Investors are now believing that those companies will give you more bang for the buck as we see the economy improve."

History is of course on our side. After the 1973-74 recession, small stocks beat larger ones for the following 10 years. Going back further, to 1932, the year before the Great Depression ended, small cap stocks beat the market for 11 of the following 13 years.

More recently, the Russell 2000 Index (the most common benchmark of publicly traded small cap companies) has gained 40.2% since the market bottomed on March 9. In that span, the blue-chip-weighted S&P 500 has climbed 24.2%.

While a 24% gain isn’t anything to sneeze at, there are a lot of penny stock investors sitting on larger gains.